Analysis of developments in financial markets, economics and public policy geared towards anyone with a stake in these issues......and, yes, we all have one.

Tuesday, September 4, 2012

China: Increased Global Linkages, Increased (and Understated) Risks

While the eyes of the investment
community were focused on Jackson Hole last week, where Chairman Bernanke was
expected to give hints whether or not the Fed would undertake additional
measures to catalyze the near comatose U.S. economy, a similarly important
question was also quietly being bandied about: What would the Chinese do? China’s
annual growth has slowed to 7.6%, below the government-mandated 8% threshold
for the first time since 2009. At the same time, inflationary pressure has been
reeled in, providing room for authorities to undertake additional stimulus.
Such a step would be of relevance given the role China’s accommodative policies
played in buttressing the global economy during the height of the financial
crisis. The question of additional action arises as both the country’s official
and HSBC’s version of the PMI index show the manufacturing sector has entered
into contraction territory.

Rather than delve deeply into the
arcane world of economic indicators, a more prudent use of this space is to go big picture and identify the many
channels through which China already impacts the U.S. and other western
economies (some obvious, others more subtle). Due to its growing influence on
the global stage, several pundits have already labeled the 21st
century as the age of China, much as the last one belonged to America. But
rather than get caught up in the hype….especially prevalent in financial
markets….of China’s inevitability, one should look beyond raw economic growth
for potential headwinds. Paradoxically, it is this rapid growth that has
exposed the country to a host of possible hurdles that its political and social
structures are ill-equipped to handle.

So Much More Than Cheap Shoes (And iPhones)

Take an informal survey on China
and most Americans would reference its epic growth rate, role as the world’s
factory and possibly the sizable chunk of U.S. government securities in its
possession. With regard to the linkages between China and the U.S., the latter
point is a good place to start. As we will continuously be reminded during the current
election cycle, America is the world’s largest debtor nation. While the private
sector deleverages, public coffers continue to expand. China accounts for 22%
of outstanding, foreign-held federal debt ($1.16 trillion). It does not invest
in Treasuries for their juicy returns (the 10-year benchmark currently yields a
laughable 1.57%), but instead because the U.S. government debt market is the
largest, most liquid and (supposedly) safest in the world. Over the past decade-plus,
such bond demand has suppressed U.S. interest rates, which in turn have spurred
Americans’ purchases of Chinese-made goods. The profits from these exports get
reinvested into more Treasuries, further suppressing rates….and the cycle
continues. As any first-year finance student learns, portfolio diversification
is a good thing, and the Chinese have not been good diversifiers. That has created
a situation that former Treasury Secretary Lawrence Summers calls The Balance of Terror. Ignoring for now
the Fed’s recent role of marginal-buyer of U.S. debt, Treasury prices depend
upon continued appetite by the Chinese. The rub is that they already own
one-fifth of the foreign-held outstanding amount. Any hint that they plan to
trim this massive exposure will send other Treasury investors running towards
the exits, hammering the value of bonds and catapulting yields through the
roof. Likely the worst affected party….aside from U.S. borrowers…would be the
Chinese as the value of their Treasury portfolio would plummet, the dreaded balance about which Dr. Summers warns.

The recycling of Chinese export
profits into Treasuries is not the only way China has impacted U.S. interest
rates. The relocation of much of the world’s manufacturing base to low-wage
countries like China resulted in a disinflationary
environment, meaning a period which saw annual inflation rates drop from the
4%-5% range to the neighborhood of 2% by the early/mid 2000s. Without upward
price pressure, the Fed was able to keep interest rates low in hopes of
spurring credit-fueled economic growth. And it worked…..well, until the worst
financial crisis in 80 years. Hindsight is 20/20.

The disinflationary impact of
China on the U.S. consumer is evidenced in the August 21st post,
which shows that prices for the goods most associated with Chinese exports
(apparel, electronics) exhibited minimal upward pressure, or actually fell,
over the past decade. Alas all good things must come to an end. Factory wages
have begun to rise and China is attempting to climb up the value-added food
chain. Already certain industries have relocated manufacturing capacity to
lesser developed, even lower cost Asian nations. China’s push towards more
sophisticated products is meeting with some success (where do you think the
iPhone is assembled?), but this foray will present challenges to western firms,
who don’t wish to share their closely guarded intellectual property with
Chinese partners for (valid) fear of getting ripped off.

“Got Any Spare Iron, Copper or Soybeans We Can Buy?”

China’s entry into the global
economy may have initially contributed to lower inflation in developed markets,
but that has given way to the country likely being a net contributor to upward
pricing pressure due to its massive demand for a range of industrial inputs. Not
only do China’s export-focused factories require raw materials, but so do the
country’s leviathan infrastructure projects, some of which have been pushed
forward in the name of stimulus. Already China is the largest user of a range
of industrial metals including, iron, copper, zinc and aluminum. Despite it
being the top producer of several of these metals, China is also the leading
importer, which has direct ramifications on global markets. And what has occurred with metals is being
repeated with energy commodities. While the U.S. remains the leading consumer
of crude oil, accounting for 20.5% of global demand, China has reached second
place with an 11.4% share. Similar to America, China only produces about
one-half of its domestic demand and must import the rest from global markets,
competing with America in the process.

As seen in the chart below, when
including all sources, China recently surpassed the U.S. as the largest energy
consumer. What it lacks (for now…..it’s changing) in crude demand, it more than
makes up with demand for coal. China accounts for nearly 50% of global coal
consumption. Coal accounts for 70% of the country’s electricity generation,
compared to less than 50% for the U.S. (a fact attributable to recent increased
natural gas production).

The upward price pressure put on industrial….and
agricultural…commodities by a rapidly industrializing China is not the only way
the country is impacting global consumers. In addition to pumping out
freighters full of goods of varying quality, Chinese factories also have
another output: pollution….and lots of it. Hand-in-hand with its position as
the world’s leading energy consumer, China now tops the charts as the greatest
emitter of carbon dioxide. Granted on a per capita basis, it is substantially
less energy intensive and polluting than industrialized nations like the U.S.,
but that is really another red flag. As automobile ownership increases and the
aspiring middle-class wants more electricity-driven gadgetry, per capital usage
and pollution will only grow. This impacts the rest of the world because discharging
emissions into the Earth’s atmosphere is like urinating in a swimming pool.
There is no special lane in which effluent stays.

A Bear in The China Shop

China’s growth rates are reason
alone for investors to seriously consider gaining exposure to the country. Even
the current soft spot towers over
European and American growth. Some naysayers state that Chinese data is not to
be trusted so how do we know the actual state of the economy? If one
amalgamates various official and private data, a mosaic arises that should at
least infer a general trend. But that is splitting hairs. The truth is China
remains the largest country in the world and authorities are doing everything
in their power to catch-up with advanced economies. All one need to do is show
up to realize the frenetic pace of growth and opportunity that remains. Three
to five years out, exposure to China-related investment themes is a no-brainer.
Farther down the road, question marks begin to arise.

Wasn’t Central Planning So 20th Century?

First among these is the fact that
China is a totalitarian regime and thus comes with all the baggage that history
tells us such governments carry. Some currently argue that China’s centrally
planned, edict-driven economy (“grow at this pace,” “build that massive
apartment block,” “lend to that state-run enterprise”) shows an alternative to
the chaotic free-enterprise system practiced by the Anglophone world. In this
respect, China is like a France, only larger and without foie gras. But such
control inevitably leads to cronyism and corruption. These regimes lack the
tools of a civil society such as an independent judiciary, solid contracts, a
nosey press and the rights for stakeholders to speak up. Without these checks, anointed
bureaucrats can comfortably continue their labors either in complete ineptitude
and/or with a lack of ethics. Centrally planned economies also quash the animal spirits necessary to fuel
entrepreneurialism and innovation. Despite China’s emphasis on math and
science, the country is a laggard in registering international patents. The educational
level…and critical thinking ability (you really think the government encourages
that skill?)…of its legion of engineers still lags behind those of its western
peers.

By suppressing all forms of
expression, except for the pursuit of material goods (plenty of rich people
there) the central authorities have inadvertently put themselves into a tenuous
position. As other authoritarian countries have allowed a middle class to germinate,
citizens begin to demand greater accountability in government, stand up to
bullying and corruption and expect to gain a voice in the nation’s future. On
the other side, one of China’s richest woman, Zhang Xin, boldly stated that the
working poor…the vast majority of the country…only have one aspirational outlet,
which is to gain the few creature comforts that others have already attained.
Should the government not be able to deliver on its promise of growth, then the
masses may not live up to their end of the bargain of not complaining about of
political repression and corruption. If anything keeps the powers in Beijing
awake at night, it’s this social unrest scenario.

Favorable Demographics? Not So Fast….

It may come as a surprise to the
casual reader, but despite its size, demographics are not in China’s favor. As
a consequence of its one-child policy, the working age population will soon
start to shrink, especially in relation to the ranks of the retired. This
creates a massive headwind for the country’s desire to increase domestic consumption.
Ironically China has an abysmal social safety net with much of the cost born by
families. In that sense, the country has all the bad stuff associated with a
communist state (iron-fisted control, human rights abuses, cheesy military
parades and septuagenarian leaders) without any of the good stuff promised by
Messrs. Marx and Engels (a workers’ utopia). With the expectation that they
must care for the elderly, younger Chinese may to pile much of their earnings
into rainy day funds rather than spend freely on creature comforts.

The Brown Cloud (And Brown Water)

Lastly, one cannot overstate the
damage being done to the country’s environment and consequently the health of
its citizens. As mentioned earlier, China is already the world’s top emitter of
carbon dioxide. Water quality…or lack thereof…is not far behind. The
ramifications for demographics, worker productivity and healthcare spending are
consequential. A crisis in the making such as this would not only impact the
global economy by diminishing China’s contribution to growth, but pollution
being pollution…and all of us stuck on the same sphere of rock air, and water…other
countries could feel the fallout from its dreadful environmental record.

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About Me

During my career as an investment analyst, several developments from the realms of financial markets, economics and public policy struck me as highly relevant, not to me in my role as a market observer, but in my role as a citizen. The subjects covered on these pages are not aimed at fellow investors or policy junkies, but to the broader population, which needs to recognize the shifts occuring in the economy and understand their consequences, as well as those of government policy.